Issues of Overhead Application without Journal Entries

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  • 0:04 Costs of Production
  • 1:13 Manufacturing Overhead
  • 2:14 Overapplied or Underapplied
  • 3:36 Manufacturing Overhead Account
  • 4:40 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Manufacturing a product requires materials, labor and manufacturing overhead. In this lesson, you'll learn how manufacturing overhead is calculated and allocated.

Costs of Production

Ms. Hare owns the Mind the Cap Company, which manufactures high-end hats. While she understands the materials and labor needed to produce her hats, she doesn't have a good understanding of how manufacturing overhead is allocated to her products and how the allocation may impact her company's profit. Let's learn with her.

As a product is manufactured, it goes through a number of processes on its way to becoming a finished good that is ready to be sold to a consumer. Manufacturing a product requires direct materials, direct labor, and manufacturing overhead.

Direct material costs consist of the raw materials that are used to create the product. Examples for Mind the Cap would include cloth and sewing thread. Direct labor costs include salaries of those employees directly involved in manufacturing, like employees in the cutting and sewing departments. Manufacturing overhead is an accumulation of costs that cannot be traced directly to an individual product and include costs such as rent on the company's production facility and depreciation (the cost associated with using an asset over a period of time) on company equipment.

Manufacturing Overhead

Since manufacturing overhead costs are not known until after the product is manufactured, companies calculate a predetermined overhead rate, an estimate of manufacturing costs based on the company's past performance or history. The formula for calculating the predetermined overhead rate is:

Estimated manufacturing overhead / Estimated total units in allocation base

The allocation base can be direct labor hours, direct labor dollars, or the number of machine hours. The determination of which base to use largely depends on whether manufacturing the product requires more labor or the use of machines.

Let's assume that Mind the Cap uses direct labor hours as its allocation base and it estimates that its annual manufacturing overhead will be $50,000 and direct labor hours will be 25,000 for the current year. Its predetermined overhead rate would be $2 per hat ($50,000 / 25,000).

Overapplied or Underapplied

Since the predetermined overhead rate is calculated using estimates at the beginning of the year, the cost will differ from the actual manufacturing overhead costs incurred. As a product is manufactured, manufacturing overhead costs are charged to the manufacturing overhead account using the predetermined overhead rate.

As actual costs become known, they are also charged to the manufacturing overhead account. At the end of the year, the balance in the manufacturing overhead account is reviewed and must be cleared out.

If the overhead allocation using the predetermined rate is greater than the actual manufacturing overhead, then overhead has been overapplied. In other words, if the guess was more than the reality. If the actual manufacturing overhead is greater than the overhead allocated using the predetermined rate, then manufacturing overhead has been underapplied. In other words, if the guess was less than the reality.

Mind the Cap applied manufacturing overhead of $225,000 during the year based on its predetermined rate, but the actual manufacturing overhead based on the products manufactured was $250,000. In this case, Mind the Cap has underapplied its manufacturing overhead by $25,000 ($250,000 - $225,000) and an adjustment is required to dispose of the difference.

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